"Economyths"

Recently I read a book called “Economyths” by David Orrell that talked about the limitations of orthodox economic theory. Here I’d like to share a section that he wrote in the introduction.

“Economics is a mathematical representation of human behaviour, and like any mathematical model it is based on certain assumptions. I will argue, however, that in the case of economics the assumptions are so completely out of touch with reality, and with the needs and behavior of most people, that the result is a highly misleading caricature. The theory is less a science than an ideology. The reason why so many people are so conned into thinking the assumptions are reasonable is that they are based on ideas from areas like physics or engineering that are part of our 2,500-year scientific heritage dating back to the ancient Greeks. Superficially they have the look and feel of real science, but they are counterfeit coin.

To make progress, it’s not enough to adjust or revise these assumptions. Much work has already been done in exploring minor variations. Instead, as a Nature article entitled ‘Economics Needs a Scientific Revolution’ put it: ‘We need to break away from classical economics and develop completely different tools.’ While economics has traditionally modeled itself after physics and mechanics, the economy has more in common with a living organism than it does with a machine.”

What is Quantitative Easing?

Source: http://danielpryorr.wordpress.com/2012/05/30/quantitative-easing-or-government-stealing/

Normally a central bank uses the official interest rate to regulate the money supply. The idea behind it is simple: if the interest rate is high, it makes borrowing more expensive and thus encourages people to save. This will reduce the money supply in the economy (contractionary monetary policy). Conversely a low interest rate makes borrowing more attractive than saving, thus increasing the money supply in the economy (expansionary monetary policy).

This is an important consideration since the supply of money directly correlates to the amount of spending in an economy. An increase in money supply (a decrease in the interest rate) will increase consumption spending and increase investment spending – which is particularly useful when the economy is in recession because it boosts the aggregate demand, which, in turn, creates the economic growth needed to get out of the recession.

But a question arises: what if an economy is in recession (low supply of money) and the interest rate is close to zero? It is illogical for the central bank to lower interest rate below zero. So what should it do? In terms of monetary policy, this is where quantitative easing steps in.

Quantitative easing is another way that a central bank increases the money supply of an economy. It is the process of injecting money into the economy that is created out of nothing. A colloquial term used here is “printing money”, but a central bank hardly does that. Instead it is done electronically by increasing the value in its credit account.

The central bank then use this newly created money to invest in financial assets that is usually owned by commercial banks or similar financial institutions. Therefore the money created is “transferred” to them. This encourages financial institutions to lend more to firms and individuals, which therefore (in theory) increases the overall economic activity, stimulating economic growth.

This sounds very good for the economy, but there are also consequences. Increasing the money supply excessively by “printing money” will cause the currency to devalue greatly, which might lead to unfavourable results like inflation or hyperinflation.  On the other hand, too little money injected into the economy will yield no results. It is very hard, if not impossible, to find out how much money is needed to produce the optimum result. 

In the year 2009, the Bank of England injected 200 billion pounds into the economy. It is said that it “helped to increase gross domestic product by between 1.5% to 2%, indicating that the effects of the programme had been ‘economically significant’” (BBC)

There are many analysts that disagree with this claim, and the thing is, and I quote from BBC:

" The simple fact is, on one knows how bad things would have been without QE (quantitative easing).

As BBC economics editor Stephanie Flanders says: ‘ Quantitative easing may well have saved the economy from a credit-led depression. We will never know.’ "

So is quantitative easing effective and useful? It is hard to say.

Boosting Aggregate Demand - The Way Forward for the Eurozone

Instead of adopting a conservative way of reducing debt by cutting back on spending, European governments should take on a more aggressive approach by doing exactly the opposite.

The Keynesian model shows that a country can be “stuck” in a recessionary (or deflationary) gap for a very long time due to downward nominal wage rigidity and insufficient aggregate demand. Keynesian economists therefore think a country must “grow” its way out of a recession, and considering the case of the Eurozone I cannot agree more. Countries in the Eurozone must boost its aggregate demand so that AD can shift to the right from AD to AD₂ and produce at the potential GDP (Figure 1). In other words, the Eurozone should make high economic growth one of their main priorities in the upcoming years.

Figure 1. Source: www.economicshelp.org

In order to achieve growth expansionary demand side policies must be in place. Firstly, the interest rates should be kept low.This way in encourages more borrowing from consumers and businesses, which therefore increases spending. Secondly, governments should increase spending in areas where there is an almost-guaranteed positive return. This is what we call fiscal stimulus packages. Such packages trigger a multiplier effect where the GDP return (or national income) exceeds the government spending that causes it and can in effect stimulate aggregate demand in an economy. An example of such investment is investment on infrastructure. This is actually what China did back in 2009, when it spent 1.5 trillion RMB on railways, roads and airport. By doing so, even in a time of global financial crisis, China maintained an impressive 9% real GDP growth rate.